iPad Mini

Last Tuesday Apple announced a refresh of their iPad, iPad mini and MacBook lines. You likely read about every piece of detail about the event, what the Apple executives wore, the nano-meter differences of the device dimensions, etc., from every major news outlet and blog.

I want to talk to you about the design of their iPad mini pricing – not the parts about how they all end in 9 or the font size they use but how this one company so effectively puts to work basic principles of pricing that are decades old.

“There are two kinds of companies: those that work hard to charge customers more, and those that work hard to charge customers less.”

It is understandable who he was referring to and why. But it is not difficult for you to see that no company in a free market with customer choices can work hard to charge more. Customers do not have to stand in line three days before product release to pay more, they have choice.

There there is the media frenzy. There are two types of bloggers- a tiny tiny fraction that understands customer segmentation and a vast majority that doesn’t. For a while the latter group has been either clamoring for or predicting Apple’s move into low end of the price spectrum with cheaper iPhones, cheaper tablets and cheaper laptops. Their ill-conceived notion stems from their focus on market share as a metric vs. a company’s profit.

A business’ goal is not to capture market share but create value for segments of customers, deliver it a price that reflects that value and maximizes its profit and of course produce it at the lowest possible cost.

Apple continues to understand this value creation (perceived or real) and designs pricing to maximize its profit over meaningless market-share numbers. Apple does not have to put an iPhone or iPad mini in everyone’s hand, after all that is the shotgun approach to marketing.

When people focus on individual details of pricing this overall objective and segmentation strategy is lost on them. It is important to get your objective right and them make sure every action, every detail and every product design feature works to further this objective.

Now let us look at iPad mini pricing through the lens of this objective.

iPad mini vs. iPad Retina – In the recent product launch Apple announced iPad Mini Retina for $399 while dropping the price of iPad mini to $299. When Apple first launched iPad mini they chose not to have Retina display on it and priced it at $329. Those who didn’t and still don’t understand the first point I made above were furious and upset. First they were surprised at the price tag compared to Kindle Fire. Second they expressed outrage at the lack of Retina display.

The first point needs no further discussion. The second point can be explained by failure to grasp customer value and willingness to pay. You do not have to beat customer expectations by a mile if an inch will do. You do not start by packing a product with features then try to monetize it. You design and deliver the Maximally Viable Product not a bundle of features.

If you are a regular reader of this blog you know I have written about my doubts about the profit impact of iPad mini. You likely also read my mea culpa on using a more pessimistic model to estimate iPad mini sales. In all likelihood they could sell about 10-12 million iPad minis per quarter.

Now the Retina part.

Why now? And why the $30 price drop in regular iPad mini?

What the $329 mini did was help expose the demand for smaller tablet and also the latent need for Retina display among those who prefer a smaller tablet. Even if 20% of these are willing to get Retina that is $140 million in additional profit (per quarter).

If you are asking why I did not subtract the cost of Retina display, that was deliberate based on my discussion of MacBook Air Retina discussion here. There is little or no marginal cost impact from the display.

But the $30 price drop on regular iPad mini means $240 in lost profit from the rest of 80% of iPad minis. If there were no changes in total demand, the upgrade percentage Apple needs to break-even is just 30% – that is 30% of current iPad mini customers select themselves to $399 ipad mini Retina.

The way to look at this how Apple most likely approached this – better understanding of demand curves and segmenation.

The 10-12 million units sold point to existence of larger demand at lower price point- as long as this price point will further the profit objective stated above. (Don’t lose sight of that for market share – it is not about capturing market share in mini tablet space)

There exists a sub-segment that values Retina display that they are willing to pay premium for it. There likely also exist another sub-segment that stood on the sidelines not buying iPad mini because of the lack of Retina.

As you combine these two factors even if the market expands to total of 15 million units with 80-20% split between iPad mini and iPad mini Retina and 50% gross margin on mini and 62% gross margin in retina (assuming same COGS as mini) — (15 million number is not far fetched from the scenario analysis I did a while back)

At the high end, Apple could sell as many as 58 million (full year), but those chances are very very slim (1 percent). Considering all the possible scenarios, the expected value of volume is 40 million.

Apple released its Q1FY13 earnings today, let us estimate how many iPad minis Apple most likely sold. The iPad mini numbers are based on the Apple‘s report.

They sold a total of 22.8 million iPads (new iPad, iPad2 and iPad mini), compared to 14.03 million in the previous quarter (pre iPad mini). If you were to attribute all incremental volume to iPad mini it comes to 8.77 million. I could stop here and say my model is correct.

If you compare the Average Selling Price (ASP) between two periods, in Q4FY12 the iPad ASP (iPad and iPad2) was $508 but it dropped to $467 this quarter (Q1FY13).

So let us plug in these numbers into the model I recently built to estimate the number of iPad minis Apple sold. We find that the 8.77 million is actually the lower limit. With the assumptions I have made, Apple likely sold 12.5 million iPad minis (all editions combined).

Apple put on some impressive iPad mini numbers. Did it cannibalize its full priced iPad? You bet it did. Last quarter Apple sold about 9.84 million full size iPad. (Again see the model.) That number dropped to 7.42 million units, thanks to iPad mini. So a cannibalization of 2.42 million units — that is 2.42 million people who would’ve chosen full size iPad chose iPad mini.

I predicted an annual expected volume (considering all possible scenarios) of 40 million. But Apple could end up selling at least 50 (4 times 12.5) million iPad minis in FY13.

What did my model say were the chances of selling 50 million (full year) units or more?

Mere 12%.

As Galbraith said I could get busy arguing that is still within my scenarios and I am still correct. Galbraith’s writings have influenced my thought process in many ways, I will note his warning and not get busy with my proof.

It indeed appears I had started with some overly conservative numbers on iPad mini uptake based on the survey results I had used. Hence my model underestimated the iPad mini volumes considerably as iPad mini yearly volume could be 50-60 million units.

Model is only as good as the informed input we start with. After all we are paid to make better hypotheses and make informed assumptions.

Like this:

Today there was a survey out from Cowan and Co that got written about in almost every blog. It is about the effect of iPad mini on iPad sales. Most quickly jumped to the obvious conclusion (in articles with catch headlines too) that iPad mini will go on to add significantly to Apple’s profit with “inconsequential” cannibalization of iPad.

Here is my representation of the survey results using the data from Cowan and Co and let me tell about the problems with this survey and hence the conclusions.

First this is a stated preference study measuring the attitude of the customer and not the actual behavior. It is well established in marketing research literature that stated preference surveys overestimate behavior at point of purchase.

Second the survey question was specific to iPad mini, asking them specifically if they would buy iPad mini in the next 18 months. They did not ask them about other tablets in their consideration set nor did they ask them if they planned to purchase Kindle Fire, Nexus or nook. That is too narrow, anchors them on single choice and ignores other possibilities. Had they asked, “Which tablet will you buy?” and reported percentage distribution of different tablets it would have been much better.

Third, they slice and dice the 24 samples who reported switching from another device to report cannibalization and conversion from other tablets. The number 24 is too small to make any meaningful estimate, especially when 8 report switching from iPad and 3 report switching from Fire. If these were accurate estimate then it also point to even smaller impact on Kindle and other tablets.

Fourth, a more significant problem with the question “What device will iPad mini replace?” is it is just plain wrong as respondents were not primed to compare price and value of each. One right way is to do a (choice based) conjoint analysis to find the respective share of different tablets – iPad, iPad mini, Fire, Nexus etc.

Fifth, let us take the 6.1% new buyers number at face value. You can interpret this as 6.1% of all those who would buy a tablet would choose iPad mini. That is, iPad mini is not bringing in many new buyers into the market. Had they asked what tablets would they buy this number would likely pale in comparison to others. So it is overreaching to say, “its low-price will bring in new customers”.

Netting it out, there is not enough validity in the data to make bold predictions about iPad mini. There are indeed many uncertainties and those are not considered let alone quantified by this study. What you have is someone’s wishful thinking supported with non-scientific sampling and analysis.

Like this:

A common analytical method in pricing is Conjoint Analysis. While this has evolved into far more sophisticated methods, at its core Conjoint Analysis is about finding how much utility different customers assign to different “features/aspects” of a product. If you know the utilities you can find how to price different product versions.

Here is a quick tutorial if you want to know more.

In the case of tablets you can think of iPad and Fire to be a collection of features (or benefits) that customers assign perceived utilities. So when you add up the utility assignment for each feature you get the total utility.

Likely true. But the point to note is the utility value from features is neither absolute nor intrinsic. It is perceived utility and it differs from segment to segment. Furthermore there are the “Fudge Factor” – the unknowns, Brand premium and Ecosystem Premium.

Apple likely found a sizeable segment – different from Amazon’s target segment – that assigns lot more value to Apple’s Brand and Ecosystem than they do for Amazon’s Brand and Ecosystem and hence is willing to pay $130 more for iPad mini. (Technically it is $95 more if you consider Fire without “Special Offers” and add price of Fire charger).

Amazon’s comparison is valid. But if the customer segments and their value allocation is not the same, then it does not matter that Fire packs better features at lower price. That is likely why Amazon decided to pull the Ad?

My question has been centered around whether or not the new device will deliver incremental (net new). No one has done some real analysis to show what the impact is. Even my article stopped short of exact numbers. Articles by others (of course) are even worse, they expect us to believe on faith that Apple will do well with iPad mini.

Now there is some real answer, based on more rigorous analysis than just claims that self-cannibalization is better.

My analysis, using statistical modeling, shows Apple may end up selling 22-52 million iPad minis but is placing a high risk bet when it comes to profit. Let us start from the beginning.

As I did before for Pinterest revenue model I chose to do Monte Carlo analysis to find impact on Apple’s profits from iPad mini. This is a reliable tool to use when there are many variables and there is uncertainty in the result. It also helps to state the result as a probability distribution instead of absolute statements we see from some of the analysts.

The model starts with listing the different variables that feed into final result and their 90% confidence interval values. That is we list all the different variables and state the low and high values that we are 90% confident about (we are 90% confident the real value is between low and high and only 10% chance the real value is outside this range).

I am going to assume contribution margin from iPad is $225 (given its 40%-50% margin numbers stated by iSuppli and others). All volume numbers are for the full year. The trade-down numbers and the “steal” numbers come from a recent market research on iPad mini preference. Steal here means how many of current nook/Kindle/nexus customers will switch to iPad mini. New sales is the number of new customers entering the market because of iPad mini. Current iPad volume numbers are based on Apple’s past four earnings reports.

It is easy to see that

Total iPad mini sales = Trade-down volume + Steal +New sales

Profit from iPad mini = iPad Mini margin X Total iPad mini sales

Lost profit from Trade-down = iPad Margin X Trade-down volume

Net new profit = Profit from iPad mini – Lost profit from Trade-down

Note that I ignored the effect on other products both iPod Touch and iPhone.

Running the model for 1600 iterations yields some stunning results.

First the total iPad mini volume numbers. These are huge. It is almost certain that Apple will sell at least 14 million units per year. There is 95% probability that they will sell somewhere between 22 million and 52 million iPad mini. And considering all possible scenarios the expected volume is 35 million units. These kind of numbers blow out the ramp up curves we have seen with any of the electronics products.

Such numbers will bring smile to those who chase market share and will delight analysts who recommend chasing market shares. But what does that do to Apple’s profit?

Here is the big surprise. Despite huge volumes, profit estimates show Apple is playing a high risk game with iPad mini.

First there is a 47% chance Apple will lose money (not including fixed costs, just the marginal costs, so the real impact can be worse).

At its worst, there is 1% chance that Apple could see $2.2B drop in its gross profit. It does not get much better, there is 15% chance Apple could see $1 B drop in its profit.

At the other end there is only 1% chance they could make $2.3B additional profit and only 13% chance they could see $1B additional profit.

Considering all possible scenarios, the expected net new profit from iPad mini is just $97 million a year.

That is not a big enough considering other R&D and marketing expenses (fixed costs).

There you have it. Apple will likely sell 34 million units in the first year but runs the risk of seeing no impact or worse significant impact on its profit.

Analysts betting on Apple stocks, thinking iPad mini will a few dollars to their EPS, take note. iPad mini is a high risk game for Apple despite assured high volumes.

Like this:

There are enough news media reports, may be they all came from the same source, about the imminent iPad Mini (a smaller and cheaper version of iPad to compete against Kindle Fire and Nexus). AllThingsD is convinced Apple has ordered 8-10 million units.

First there were “confirmed rumors” about invites going out on October 10th. Now they have retreated to another “confirmed rumor” about October 23rd event.

It is possible all these sources are true and Apple will go on to release a iPad Mini. But I find it still difficult to see a scenario where the lower priced iPad Mini can deliver incremental (net new) profit.

“Like other products, lower price points tend to drive sales. An iPad Mini we think would likely drive incremental iPad buyers,” Wu said in a phone interview with TheStreet. “There’s going to be some cannibalism of iPad sales, but we think it makes a lot of sense.”

I am not sure if Wu followed Apple’s pricing strategy so far. Besides he seems to miss the point that lower price points also kill profits. Apple, however, never chased market share. Shaw Wu is not alone on this, there are many stock analysts and others who seem to think “some cannibalism is not bad”.

Exactly how bad is the cannibalism? Well for starters it is not about sales volume or revenue, it is about profits. Contribution margin on iPad is 42%-50%. That is, $210 to $250. Given that we are hearing (from analysts) either $199 or $299 price point for iPad mini and that we know from Amazon that they are selling KIndle Fire at cost, it is highly likely contribution margin from iPad mini is in the range $10-$100.

I cannot see a scenario Apple selling anything at cost.

So for each unit of $499 iPad cannibalized, Apple has to sell 2 to 25 iPad minis. If we assume average, that is 13.5 iPad Mini for every iPad sales lost. Is that doable? Let us look at recent market research numbers on customer preference for iPad in the presence of cheaper iPad mini (second degree price discrimination)

35% of iPad owners surveyed by deal aggregator TechBargains.com say they’d trade in their old model for the smaller tablet

However, only 18% of all respondents in the TechBargains survey say they want the new gadget,

These are not good numbers. Presence of lower priced iPad, packed with value, will cause more than one third of current iPad customers to trade down. This can be compensated only if the 18% of the total addressable market for iPad mini (those who will not buy $499 iPad) is greater than 35% of iPad market.

One way for Apple to reduce the magnitude of this trade down is to what railways did in the past with their third class cars. For railways there was a big market of low price travelers (and they had excess capacity). They wanted to attract these low price travelers but did not want to lose the high contribution margin from those second class (or first class) travellers trading down to cheaper third class. So to ensure those who can afford will continue to choose the second or first class the railways removed roof from their third class cars.

Apple could do something similar and cripple their iPad mini such that only the most cost sensitive segment will self-select to this version while the higher willingness to pay segment will continue to prefer the full iPad. But that is complicated by the presence of really good alternatives at these lower price points.

Even for those who would buy an iPad mini, there are many options at the $199-$299 price points.

The $199 price point is crowded with feature rich tablets and there are two others delivering great value at $269 and $299 price point. Not to mention the $399 iPad2 which offers better value than a $299 iPad mini. Apple cannot cripple its iPad mini and expect to win against these value packed alternatives.

The cannibalization does not end with just iPad. It also extends to iPad Touch.

At $199 and $299 price points Apple will compete with its other product line – iPod Touch. Since the 7″-8″ tablet will deliver lot more value than iPod Touch for the same price more will switch from these high contribution margin units.

Considering Apple’s practice of effective pricing (note the fact that they did not introduce a $199 new iPod Touch) and effective use of product versions at multiple different price points I do not see Apple entering this field. Even if they did, it is only 10-30% chance this new product will result in net new profits.